Throw out conventional wisdom about small biz banking choices

Get ready to reconsider everything you think you know about small, privately held businesses and their banking relationships.

A new discussion paper from the Federal Reserve tosses conventional wisdom about small business and banking on its head.

The authors found that small business are not more likely to have a community bank as their main bank, despite commonly held perceptions.

The conventional paradigm suggests that community banks - smaller, single-market and locally based financial institutions - are better able to form strong relationships with small firms that are “informationally opaque” and are smaller or younger, with owner-managers who have large stakes in their firms. At the same time, megabanks - large, multimarket, nonlocal institutions - tend to serve more transparent firms, or those that are larger and publicly held, conventional wisdom suggests.

Authors of the recently released discussion paper tested those commonly held beliefs using data from the 2003 Survey of Small Business Finance. They found that three-quarters of the firms in their sample have large banks as their main banks, and about 60 percent have multimarket or nonlocal banks as their main banks. “The high proportion of firms that have large, multimarket or nonlocal banks as their main banks suggests, initially, that the conventional paradigm does not hold – most of our small firm sample do not have community banks as their main bank,” authors wrote.

Small business’ choice of large banks could be motivated, in part, by the convenience of having a large share of branches in the area, according to the paper.

There’s mixed evidence on whether small and privately held companies have stronger relationships with their main banks, “but the evidence is clearer that strength does not depend on the type of bank,” the paper said.

Two key changes may be the reason the conventional paradigm does not hold. There have been changes in lending technology, specifically the introduction of credit scoring in small business lending, and there have been changes in bank regulations, including rules that allow big banks to integrate offices across state lines.

The authors cited participants in the Federal Reserve Bank of Atlanta Conference on Small Business, Entrepreneurship and Economic Recovery, among others, for research assistance.